Not Afraid of Debt

Mike Breen: Greetings, this is Mike Breen from Morningstar, and I am here with Mike Maloney from Skyline Asset Management, a Chicago-based value shop. Welcome, Mike.

Mike Maloney: Hi, Mike.

Breen: How are you?

Maloney: Good.

Breen: Your shop tends to own firms that have a hair more debt than the benchmark but have good interest coverage, cash flows etc. And that didn't seem to matter in 2008. You guys took some hits, but now ironically those same firms are back. How do you deal with something like that and do lessons learned without over-shooting the mark and trying to win in the last war.

Maloney: Sure. We definitely look at companies that we believe have strong financial characteristics, but we're not afraid of debt. We look at companies and if we think the business model supports it, if the margins support it and there's good interest coverage as you mentioned, we'll invest in companies like that. And oftentimes, we'll buy companies that might take on debt in terms of an acquisition and again if we see the opportunity is there to grow the earnings, but at the same time maintain a good financial structure, we'll take advantage of the opportunity.

I think in 2008 there was so much panic. In 2008 any amount of debt was considered bad, and any company that had any level of debt was considered to be at risk in terms of liability. And we really didn't believe that. We knew that we were going to go through some tough times in a difficult economic environment, but the companies that we owned we felt had strong business models, good market positions, and good coverage, and so, when we got through the panic late in 2008 and into 2009, investors stepped back and stopped focusing just on the amount of debt on balance sheets and a company's ability to handle that debt. I think they responded very positively to our stocks, and we saw a lot of the stocks rebound nicely.

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Breen: For a value shop it's interesting that you actually own a decent number of tech names, and those have done really well. Your fund has done well this year. Part of it's rebounding some of those names that were hurt, but some of the tech names have done well. Maybe you can touch on that a bit.

Maloney: We think that we've been drawn to the technology sector primarily because of valuations, and unlike a lot of the economy, tech really had its big decline earlier on in this decade and didn't really bounce back like a lot of other sectors, particularly on the industrial side. So, you have a lot of companies that have low valuations. You had a lot of cautious management, so they did keep a lot of powder dry. You have a lot of companies that had a lot of cash on their balance sheet and net cash that was a good percentage of their overall market capitalization.

These were good niche companies with good market positions, relatively low, but improving margins, and so it was really an ideal situation for us, low valuations on depressed earnings. And so, the slowdown in the economy has caused a pause in terms of the earnings recovery for a lot of these companies, but they still remain on track and still have very good valuations.

Breen: Any particular names in your top 20 or so that have done well that you're still sticking with and believe strongly in?

Maloney: [Although the portfolio is] broadly diversified among the technology stocks, one of the areas that is somewhat concentrated is telecommunication services, companies that provide services to benefit transaction processing. A good example of a company, actually the best performer year to date in [2009], is a company called TNS. TNS is a company that we bought in 2008. They basically do the connectivity between point of sales retail.

Breen: It's like a secure network ...

Maloney: Exactly, it's a secure network that allows connectivity between the point of sale and the credit card issuer. TNS is a good example of a company that's had a little bit of debt. They actually added some debt through an acquisition. The fundamentals have held up pretty well. Two-thirds of their business is outside the U.S.

Breen: Did they make the acquisition from one of the bigger firms like VeriSign?

Maloney: VeriSign, exactly, a company called VeriSign. It's a business [called CGS] that you probably know most for caller ID. So, if you've got a phone that has somebody's name pop up, it's probably ... CGS' software. It's a nice business. We think it grows in the mid-single digits, but VeriSign is looking to grow even faster than that. So, this wasn't a core operation for them, and so they were shopping it for quite some time. We think that TNS got a very, very attractive price.

For example, we think ... T&S is going to earn about $1.80 [per share] this year, and of that about 35 cents is coming from accretion from this acquisition because they bought it very attractively and bought it at a good price. And that doesn't even include any revenue or cost synergies that they think they are going to get.

Breen: One firm's pain is another one's gain.

Maloney: That's right...